Economics 302 (Sec. 001)( )Intermediate Macroeconomic Theory and Policy(Spring 2011)Theory and Policy (Spring 2011)4/25/2011Instructor: Prof. Menzie ChinnInstructor: Prof. Menzie ChinnUW Madison21‐1 The Medium Run*EPPε=•There are two ways in which the real exchange rate can adjust:EorP&P*Padjust: E, or P& P*•The aggregate demand relation in an open economy with fixed exchange rate isfixed exchange rate is,,*EPYY GTP⎛⎞=⎜⎟⎝⎠P⎝⎠() , + , −−2of 32M/P doesn’t appear, but real rate does.21‐1 The Medium RunAtDdUd Fi d Eh RtAggregate Demand Under Fixed Exchange Rates,,*EPYY GTP⎛⎞=⎜⎟⎝⎠•In a closed economy, the aggregate demand relation took the same form b f h f h l k / d fP⎝⎠() , + , −−as above, except for the presence of the real money stock M/P instead of the real exchange rate ĒP/P*.–Under fixed exchange rates, the central bank gives up monetary policy as a policy instrument. This is why the money stock no longer appears in the aggregate demand relation.– At the same time, the fact that the economy is open implies that we must include a variable that we did not include when looking at the 3of 32closed economy earlier, namely, the real exchange rate, ĒP/P*. 21‐1 The Medium RunEquilibrium in the Short Run and in the Medium RunFigure 21–1Aggregate Demand and Aggregate Supply in an Open Economy Under Fixed Figure 21 1An increase in the price level leads to a real appreciation and a decrease in output: The Exchange Rates and a decrease in output: The aggregate demand curve is downward sloping. An increase in output leads to an increase in the price level: The increase in the price level: The aggregate supply curve is upward sloping. 4of 3221‐1 The Medium RunE ilib i i th Sh t R d i th Mdi RThe aggregate supply relation is:Equilibrium in the Short Run and in the Medium Run(1 ) 1 ,eYPP F zLμ⎛⎞=+ −⎜⎟⎝⎠•The price level P depends on the expected price level Pe, and on the level of output Y. There are two mechanisms at work:L⎝⎠– The expected price level affects nominal wages which affect price levels.levels.– Higher output leads to higher employment, which leads to lower unemployment higher wages and higher price levels5of 32unemployment, higher wages, and higher price levels.21‐1 The Medium RunE ilib i i th Sh t R d i th Mdi REquilibrium in the Short Run and in the Medium RunFigure 21–2The aggregate supply curve Adjustment under Fixed Exchange RatesFigure 21 2gg g pp yshifts down over time, leading to a decrease in the price level, to a real depreciation, and to an increase in output. pThe process ends when output has returned to its natural level. 6of 3221‐1 The Medium RunTh C f d itDltiThe Case for and against a DevaluationFigure 21–3A devaluation of the right size Adjustment with a DevaluationFigure 21 3gcan shift aggregate demand to the right, moving the economy to point C. At point C, output is back to the natural level of output. 7of 32The Return of Britain to the Gold Standard:The Return of Britain to the Gold Standard: Keynes versus ChurchillThegold standardwas a system in which each country fixedThe gold standardwas a system in which each country fixed the price of its currency in terms of gold and stood ready to exchange gold for currency at the stated parity. 8of 3221‐2 Exchange Rate Crises under Fixedh• Suppose a country is operating under a fixed exchange rate, and that fi i l i bli i h b hExchange Ratesfinancial investors start believing there may soon be an exchange rate adjustment: – The real exchange rate may be too high, the domestic currency may b ldbe overvalued.– Internal conditions may call for a decrease in the domestic interest rate, a decrease in the domestic interest rate cannot be achieved d fi d h tunder fixed exchange rates. If credible, then what is true is:()()tetttEEEii−−=+1*9of 32tttE21‐2 Exchange Rate Crises under Fixedh•Expectationsthat a devaluation may be coming can trigger anExchange Rates•Expectations that a devaluation may be coming can trigger an exchange rate crisis. The government and central bank have a few options:– They can try to convince markets they have no intention of deva luing.– The central bank can increase the interest rate.– Eventually, the choice for the central bank becomes either to increase the interest rate or to validate the market’s expectations and devalue.10 of 32The 1992 EMS Crisis11 of 32Exchange Rates of Selected European Countries Relative to the Deutsche Mark, January 1992 to December 1993Figure 121‐3 Exchange Rate Movements underFlexible Exchange Rates•Take the interest parity condition:Flexible Exchange RatesE*1(1 ) (1 ) ttettEiiE++=−•Multiply both sides by1i+1etE+Th it th ti ft+1 th th ft1*11ettttiEEi++=+•Then write the equation for year t+1 rather than for yeart:11etiEE++12 of 3211*211ettttEEi++++=+21‐3 Exchange Rate Movements underlibl hThe expectation of the exchange rate in year t+1, held as of year t, is given byFlexible Exchange RatesReplacingwith the expression above gives1*12111eteeetttiEEi+++++=+eEReplacing with the expression above gives1(1 )(1 )eettiiEE+++=1tE+Continuing to solve forward in time in the same way we get**21(1 )(1tetttEEii++++()()()()()()11 1 ... 1eeett tnii iEE+++++=13 of 32()()()1** *11 1 ... 1t tneett tnEEii i+++++++21‐3 Exchange Rate Movements underFlexible Exchange Rates•Any factor that moves the current or expected futureExchange Rates and Current and Future Interest Rates•Any factor that moves the current or expected future domestic or foreign interest rates between year t and t+nmoves the current exchange rate. Exchange Rate VolatilityThe relation between the interest rate itand the exchange rate Etis all but mechanical A country that decides to operate underg yis all but mechanical. A country that decides to operate under flexible exchange rates must accept that it will be exposed to fluctuations over time.14 of 3221‐4 Choosing betw. Exchange Rate RegimesShould countries choose flexible exchange rates or fixed exchange rates?– In the short run, under fixed exchange rates, a country gives up its control of the interest rate and the exchange rate.Alti i ti th t t b btt dlit–Also, anticipation that a country may be about to devalue its currency may lead investors to ask for very high interest rates.–Anargument against flexible exchange rates is that they mayAn argument against flexible exchange rates is that